6. Economic Outlook

The International Economy

The Bank's forecast for growth in Australia's
major trading partners is little changed from the August
Statement for both 2013 and 2014. In 2013, trading partner growth
is expected to remain slightly below its decade average
of around 4 per cent before picking up to about 4¼
per cent in 2014 (Graph 6.1).
This forecast is similar to those published by other
forecasters.

For most countries, revisions to expected growth for
2013 since the previous Statement reflect
published data for the second and third quarters,
with relatively small changes to the outlook for the
remainder of 2013 and for 2014. The Chinese economy
is expected to grow a little faster in 2013 than previously
anticipated, though still close to the government's
target of 7½ per cent. This follows stronger-than-expected
September quarter data and an upward revision to GDP
in the June quarter. Domestic demand is expected to
remain strong. In Japan, average growth over the forecast
period is anticipated to be similar to the pace seen
over the past year or so, although the increase in the
consumption tax and the newly announced temporary fiscal
stimulus are likely to see growth stronger in the near
term than further out. In the rest of east Asia, growth
for 2014 has been revised down a little, more so for
the middle-income countries. Notably in Indonesia, the
combination of high inflation and the tightening of
monetary policy is expected to weigh on activity. The
outlook for India is also a bit softer, given the recent
weakness in activity and tighter monetary and fiscal
policies.

In the United States, the economy is expected to gather
momentum gradually through 2014, given very stimulatory
monetary policy and progress already made in repairing
private sector balance sheets. The recent partial shutdown
of the US federal government and the protracted negotiation
of an increase in the debt ceiling are likely to have
had only a minor negative effect on the recovery. Economic
conditions have improved a little in the euro area in
recent months and, while activity remains weak, the
economy is expected to record positive growth in 2014.

Over the second half of 2013, the terms of trade are
forecast to retrace the gains seen over the first half
of the year and then decline gradually thereafter as
the global supply of bulk commodities increases
(Graph 6.2).
The overall profile is slightly higher than it was
in the August Statement, in part
reflecting higher-than-expected prices received
for iron ore of late.

Domestic Activity

In preparing the domestic forecasts, a number of technical
assumptions have been employed, as usual. The exchange
rate is assumed to remain at its current level over
the forecast period (A$ at US$0.95 and the TWI at 72,
which is around 5 per cent higher than was assumed in
the August Statement but still 7 per cent
lower than assumed in the May Statement).
The forecasts are based on the price for Brent oil remaining
at US$104 per barrel, the same as the assumption in
August. The cash rate is assumed to be unchanged over
the forecast period at 2.50 per cent. The low level
of the cash rate has resulted in variable borrowing
rates below their 2009 lows. The working-age population
is assumed to grow by 1.8 per cent each year, drawing
on forecasts by the Department of Immigration and Citizenship
and in line with the August Statement.

The starting point for the forecasts of the Australian
economy is below-trend growth over the year to
the June quarter 2013,
with several factors weighing on growth – the
fall in mining investment, moderate consumer spending
growth and ongoing fiscal restraint. The available indicators
suggest that growth remained below trend in the September
quarter. Retail sales and the Bank's liaison point
to moderate growth of household spending. Measures of
current business conditions from surveys have been below
average for some time. Consistent with this, non-mining
investment intentions remain subdued, while the decline
in mining investment has much further to run as large
mining projects continue to reach completion.

On a more positive note, indicators of business and
consumer confidence have risen to above-average levels
in recent months. It is too early to know whether this
pick-up will be sustained and whether it will transmit
to economic activity. In one area where confidence has
been building for longer, namely the housing market,
indicators of dwelling investment continue to point
to further growth. Resource exports growth has remained
strong as investment projects reach completion, thereby
adding to productive capacity.

GDP growth is now expected to remain below trend at
close to 2½ per cent through to the end of 2014,
before picking up to above trend by the end of the forecast
period (Table 6.1).
This outlook is a little weaker over 2014 than at
the time of the August Statement, as the
latest liaison information points to a more
pronounced fall in mining investment over 2014, with
some large projects delayed or looking less likely to
proceed. The appreciation since the August Statement
means that the still high level of the exchange rate
is also expected to constrain activity in the traded
sector by more than was expected three months ago. For
consumption, the positive effects from various indicators
of household sentiment are judged to be mostly offset
by weaker prospects for growth of household income,
owing to the labour market remaining soft through 2014.

Overall, the outlook for below-trend growth over the
coming year reflects the substantial fall in mining
investment, planned fiscal restraint and the still high
level of the Australian dollar. On the other hand, low
interest rates are stimulating dwelling construction
as well as prices and turnover in the established housing
market. It is likely that these trends will be associated
with stronger growth in household consumption over time.
Subsequently, this pick-up in demand, and the improvement
in consumer and business sentiment, is expected to flow
through to stronger non-mining business investment,
which would contribute to higher GDP growth over 2015.

The outlook for household consumption is in fact a little
stronger than at the time of the August Statement,
reflecting the balance of forces pushing in two directions.
An impetus to consumption has come from the strengthening
conditions in the established housing market, with increased
turnover and prices, as well as higher equity prices
and the apparent improvement in consumer confidence.
Working in the other direction is slower income growth,
given softer wage outcomes and expectations for slightly
slower employment growth (reflecting the downward revision
to aggregate GDP growth). Overall, while growth of consumption
spending is expected to be below trend over the remainder
of 2013, it could rise to a bit above trend by the end
of the forecast period. With consumption spending expected
to grow faster than incomes, consistent with rising
wealth, the forecasts embody a modest decline in the
household saving ratio towards the lower end of the
range seen over recent years.

The recovery in dwelling investment is expected to continue,
and to accelerate somewhat, over the forecast period.
The environment for this form of investment remains
favourable, with low interest rates, rental yields that
are around the highest they have been for a decade and
support for first home buyers that favours construction
of new dwellings. Stronger conditions in the established
housing market will also promote investment, including
renovation activity (which tends to rise with higher
housing turnover). Building approvals and other forward-looking
indicators, such as loan approvals and first home owner
grants for new construction, are consistent with a recovery
in dwelling investment.

With governments at both the federal and state levels
planning to undertake fiscal consolidation over the
next few years, growth of public demand is expected
to be very low relative to its historical average. Consistent
with budget projections, the contribution to GDP growth
from public demand over the forecast period is expected
to be around one-third of its historical rate. This
outlook has not changed since the previous Statement;
at the federal level more detail will be available
in the Mid-Year Economic and Fiscal Outlook.

The outlook for mining investment has been revised lower,
particularly in 2014/15, primarily due to a reappraisal
of the prospects for investment in the coal sector.
A range of information points to some delay in the expansion
of coal mining, and the viability of some of this expansion
being more tentative than previously considered. Investment
in iron ore and liquefied natural gas (LNG) extraction
has also been revised down a little. While the expectations
component of the ABS capital expenditure (Capex) survey
remains strong for the mining sector, this is inconsistent
with the lack of new commitments to mining projects
and a lack of current expenditure on development and
planning work that would precede new projects. Given
this, it is expected that mining investment will continue
to decline, but to do so more rapidly from around the
middle of next year. The share of mining investment
in GDP is anticipated to decline by around
3 percentage points
over two and a half years. The impact on GDP will be
smaller in magnitude than the decline in mining investment
because a large share of this investment spending is
estimated to be on imported capital goods.

Overall, non-mining investment is expected to remain
subdued in the near term. Surveys of firms' intentions
suggest that there will be little growth in non-mining
business investment over the next year or so. Also,
office vacancy rates have increased and measures of
capacity utilisation have been a little below average.
Non-residential construction is, however, expected to
be supported by the large stock of work planned or currently
underway, most notably in the healthcare sector. Further
out in the forecast period, non-mining investment is
expected to pick up given the low level of investment
and hence low growth of the non-mining capital stock
over recent years, the low level of interest rates,
increasing consumption growth and strong population
growth. The recent pick-up in measures of business confidence
and the depreciation of the exchange rate since earlier
in the year support this outlook.

Prospects for export volumes remain good and exports
are expected to make a significant contribution to GDP
growth in the coming years. Given the significant investment
that has occurred to date and is still underway, bulk
commodity exports are expected to increase strongly
over the next few years. Growth of resource exports
is expected to pick up even more noticeably from 2016
as new LNG production facilities come on line.

With output growing below trend, the labour market has
softened over 2013. The level of employment is little
changed since earlier in the year, although total hours
worked have continued to grow with an increase in average
hours worked. The unemployment rate remains on a gradual
upward trend and the participation rate has declined.
The near-term outlook for employment remains soft. Forward-looking
indicators of employment growth generally appear to
have stabilised after falling through most of the year,
although they remain at low levels. Further out, the
more subdued outlook for mining investment and so for
aggregate activity has seen the profile for employment
revised down slightly. The winding down of mining investment
from very high levels is likely to weigh on employment
growth, with industries that provide inputs to mining
investment projects – such as construction and
business services – particularly affected. Unemployment
is anticipated to continue to increase gradually for
the next year or so as the economy grows at a below-trend
pace. Later in 2015, the improvement in non-resource
activity is expected to see employment growth pick up
and unemployment begin to decline.

Consistent with spare capacity in the labour market,
wage growth has eased across states and industries over
the course of the past year. On some measures, wage
growth has been around its slowest pace in a decade.
Wage growth is expected to remain contained over the
forecast period, owing to the labour market remaining
soft for the next one to two years and pressures on
firms to contain costs. Various leading indicators of
wage growth, including surveys of firms' wage expectations
and information from the Bank's liaison, also indicate
that wage pressures are likely to remain limited. Overall,
wage growth is expected to remain below 3 per cent over
most of the forecast period.

Inflation

The forecasts for inflation are little changed, notwithstanding
some influence from a slightly higher-than-expected
outcome for the September quarter, the slightly weaker
labour market and higher exchange rate.

The quarterly rate of inflation picked up in the September
quarter, by a bit more than expected, boosted by a rise
in fuel prices. Year-ended inflation declined as the
direct effect of the earlier introduction of the carbon
price dropped out of the calculation. The various measures
suggest that underlying inflation was around ½–¾
per cent in the quarter and the year-ended pace of underlying
inflation was a touch lower than a quarter ago, at a
little above 2¼ per cent.

While the exchange rate has appreciated since the previous Statement,
it remains lower than earlier in the year. Accordingly,
higher import prices are expected to add to inflation
over the course of the next few years, but by a bit
less than was expected three months ago. Higher import
prices are expected to begin to exert an upward influence
on tradables prices in the next few quarters, with increasing
prices for tradables items likely to become the norm,
in contrast to the deflation in these items experienced
in recent years. Altogether, the forecasts anticipate
that the rise in import prices will contribute up to
¼ percentage point to the annual rate of inflation
over the forecast period.

Working in the other direction, the subdued outlook
for the labour market in the near term is likely to
exert downward pressure on wages and so inflation. Unit
labour costs have been unchanged over the past year
and growth of these costs is expected to remain contained
over the forecast horizon. Accordingly, domestically
generated inflationary pressures are likely to remain
modest.

Inflation will also be affected by the price of carbon.
As in the previous Statement, the forecasts
incorporate a path for the carbon price
that is based on current legislation, which stipulates
a move from a fixed to floating carbon price on 1 July
2015. This would be likely to see the carbon price fall
to be similar to the price of European permits. In line
with projections in the Australian Government's
budget, the forecasts assume a floating price of around
$12 in 2015/16, down from the fixed price of around
$25 in 2014/15. This change is expected to subtract
under ½ per cent from CPI inflation in 2015 and
around half that much from underlying inflation.

The government has stated that it intends to repeal
the carbon price on 1 July 2014. Based on modelling
by Treasury, the introduction of the carbon price was
expected to add 0.7 per cent to the CPI and it seems
reasonable to assume that its removal would result in
a reduction in the CPI of a similar magnitude. Under
this outcome, the forecast for CPI inflation would be
lower by around 0.7 percentage points over the year
to June 2015 at 1¼–2¼
per cent (with inflation
in the subsequent period being higher than the current
forecasts because the price of carbon would not be declining
in that period). Underlying inflation would again respond
by less than this, with the forecasts a little more
than ¼ percentage point lower over the year to
June 2015 at 1½–2½ per cent. The
government has also stated its intention to increase
tobacco excise in a sequence of steps over the next
four years. These increases, which are not incorporated
in the forecasts, would be expected to add a little
less than ¼ percentage point to the forecasts
for headline inflation over each of the next four years,
but not affect underlying inflation.

Risks

Just as the forecast for trading partner growth is little
changed from the August Statement, many of the
risks surrounding those forecasts are
as they were three months ago. For most economies, the
risks appear broadly balanced. The notable exception
remains the euro area, where risks to growth appear
to be to the downside given the still weak state of
the economy and ongoing need for resolution of banking
and fiscal problems. However, the risks in the euro
area economy may be becoming slightly more balanced
with the improvement in conditions apparent over the
past six months or so.

In China, after the authorities had signalled concern
about the rapid expansion of financing earlier in the
year, there was a noticeable decline in the extent of
new borrowing. In August and September, however, growth
of bank and non-bank lending rebounded. It remains to
be seen how sustained this rebound will be. A renewed
effort to address the build-up of debt could slow the
pace of borrowing and so some forms of economic activity.
On the other hand, failure to contain the build-up of
risks in the financial system may strengthen activity
in the near term but presents risks to the economy further
out. Policymakers also face challenges calibrating and
implementing structural reforms: a program of significant
reforms could raise the potential growth of the economy,
but a failure to reform could constrain future growth.
A key meeting of the Chinese Communist Party in November
is expected to provide more detail on the plans for
reform.

Following the two and a half week partial shutdown of
the US Government, there has been only a temporary resolution
of the fiscal problems, with further agreement needed
by early next year to continue funding government operations
and increase the debt ceiling. While the most recent
events appear to have had little impact on the ongoing
recovery in economic activity, the potential for another
shutdown or protracted debt ceiling negotiations could
contribute to ongoing uncertainty for firms and households,
and hamper the recovery. Moreover, uncertainty about
the timing of withdrawal of the extraordinary monetary
stimulus in the United States has increased. This has
resulted in some substantial moves in financial market
prices and sentiment. When expansionary monetary policy
settings are eventually pared back in the United States,
financial conditions could tighten disproportionately
in developing economies, with the possibility for negative
effects on economic activity. How policymakers in these
economies prepare for, and respond to, these possibilities
will have a bearing on growth outcomes.

In Japan, for the improvement in economic conditions
to persist, there will need to be sustained increases
in business investment. The increase in the consumption
tax next April will be an important hurdle for the Japanese
economy, although the announcement that the tax rise
will be accompanied by a temporary fiscal stimulus improves
the prospects for growth at that time. There continues
to be little information about the proposed structural
reforms, which are critical to raising the potential
growth rate of the Japanese economy.

For the Australian economy, there remains substantial
uncertainty about the transition as mining investment
declines and other sources of growth pick up. While
the prospects for resource exports remain strong, there
is considerable uncertainty around the forecasts for
mining investment. This uncertainty manifested itself
more recently with a reassessment of the prospects for
coal investment. While there could be further cost overruns,
there is little planning and development underway for
new projects, which would suggest little upside risk
to the profile for mining investment activity in the
near term.

The forecasts encompass a recovery in non-mining business
investment that is more muted than in past cyclical
upturns. While this seems likely in the near term given
current economic conditions and leading indicators,
the low level of non-mining business investment in recent
years, together with the freeing up of labour from mining
investment projects and stimulatory financial conditions,
could eventually see non-mining investment pick up at
the faster rates seen in some past upturns. While a
faster recovery would seem more likely if the recent
improvement in business confidence is sustained, past
experience indicates that it is very difficult to predict
when such a strong cyclical upswing in business investment
may occur.

If housing market conditions strengthen more substantially,
the associated boost to wealth and sentiment could result
in lower saving and stronger-than-expected consumption
growth. If this were accompanied by a return to increasing
household leverage, it could raise concerns from the
perspective of financial stability, although to date
growth of housing credit overall remains moderate. On
the other hand, there is a risk that households become
more cautious in the face of slower income growth, resulting
in weaker consumption growth.

The weak outlook for growth of public demand is consistent
with the fiscal consolidation underway and that which
is planned. The forecasts imply that growth of public
demand over the next few years will continue to be the
weakest seen for at least 50 years. It is possible that
with below-trend growth in the economy in the near term,
governments will not restrain spending growth to the
extent assumed.

A significant uncertainty for the forecasts is the path
of the exchange rate. The forecasts are, as usual, predicated
on a constant exchange rate. The exchange rate appreciated
significantly during the past decade as higher commodity
prices led to a boom in mining investment. The higher
exchange rate shifted demand toward external sources,
so relieving pressure on domestic capacity to accommodate
the substantial increase in mining investment. The decline
in mining investment, even if commodity prices remain
high, will result in a reduction in the capital inflow
that has been funding that investment and a reduction
in domestic demand, and so could well result in a lower
exchange rate. A further depreciation similar in magnitude
to that seen earlier this year could be expected to
see growth return to trend, or even above trend, sooner
than forecast and assist with the required rebalancing
of growth in the domestic economy. A depreciation of
this size could also see inflation move into the top
half of the target range for a time.

If the recent pick-up in confidence were to be even
more durable than expected, employment and inflation
might also be expected to pick up. Following a long
period during which firms outside the mining sector
have been reluctant to take on new risks and have been
focused on containing costs, a shift in confidence might
translate into more employment growth than has been
assumed, thereby lifting labour costs and inflation
somewhat. However, if the transition to non-mining led
growth were to progress less smoothly than anticipated,
then the labour market could weaken by more than is
expected, resulting in lower inflation outcomes. The
need for labour to shift to non-resource related jobs
might also see a period during which there is an increased
mismatch between the skills required for vacant jobs
and those of available workers, pushing up unemployment
for a time as well as limiting the economy's potential
to grow without generating additional wage growth.

These identified, and other unknown, risks mean that
the path for GDP and inflation may well differ from
the forecasts presented. One way of demonstrating the
uncertainty surrounding GDP and inflation forecasts
is to present confidence intervals based on historical
forecast errors (Graph 6.3
and Graph 6.4).[1]